Alternative ETF Weighting Methodologies 101 - ETF Education

By
A A A
Share |

In the beginning, there weren't exactly a wealth of options for investors seeking alternative weighting methodologies beyond the gold standard, market cap-weighting. This process, which gives the largest weights to the biggest companies, has grown to dominate the market for a few reasons. First, market cap-weighting tends to be easy to maintain and requires little in terms of rebalancing. Firms such as ExxonMobil or General Electric seem destined to always be giant companies meaning that funds can count on these companies to always make up large chunks of a cap-weighted portfolio.

Additionally, for large funds, it is very easy to trade in big stocks such as Exxon and other large caps, as the volume for these securities is immense. This is in stark contrast to some smaller names which cannot rival the deep liquidity offered by the stocks that are on the DJIA or other mega corporations. Thanks to these factors, as well as the popularity of and ubiquitous nature of cap-weighted indexes such as the S&P 500, the method remains by far the most popular choice for ETFs as well.

However, the golden age of cap-weighting appears to be ending as there are a number of other techniques which are gaining a cult following among many investors. These relatively new methods seek to break the link between stock price and weight, potentially giving investors a better way to play markets. This is because many believe that cap weighting is fundamentally flawed as the technique overweights overvalued securities and underweights undervalued securities putting investors at a disadvantage over the long haul.

In light of this, a number of issuers have staked their claim in the 'alternative weighting' space, seeking to build a suite of products that have a particular methodology. Below, we highlight some of the most popular alternatives to market cap-weighted products, highlighting some of the pros and cons to each method as well as some of the issuers that employ these techniques. While no method is universally superior to cap weighting or to the other alternative weighting methodologies, it is very important to know what kind of markets these funds may outperform (or underperform) in and what their own biases are in their portfolios.

Earnings

If an investor is seeking to avoid risky, unprofitable companies, the earnings-weighted methodology could be the way to go. This technique screens out companies that are losing money and then adds up all the earnings in the component group and gives each company their proportionate share of the aggregate earnings as their weight in the fund. This gives investors exposure to a basket of lower risk stocks that can reduce overall volatility. The fund also focused in on 'core earnings' so investors can rest assured that one-time earnings boosts and asset sales do not overtly impact the weightings of the product. Currently, earnings-weighting is used by WisdomTree and their suite of ETFs. The company has six ETFs using earnings-weighting focused on the U.S. as well as a few others in the international space, primarily the WisdomTree India Earnings ETF ( EPI ).

While this strategy may sound intriguing, investors should be aware of a few limitations. An earnings focus can often overweight a portfolio towards value stocks making any funds based on this idea likely to outperform in down markets and underperform in bull markets. From a sector perspective, companies with big profit margins (financials, health care) tend to be at the top while low profit margin businesses (utilities, materials, telecoms) tend to stay near the bottom. This is likely because these high profit margin firms have an easier time generating earnings and thus can make up bigger weightings in a particular earnings-weighted fund.

Dividends

For income focused investors, using dividend weighting can be an intriguing alternative. Funds using this technique only include companies that pay cash dividends and weight the portfolio by the dollar value of this metric that is paid out to investors. This could be an interesting choice that may give a portfolio a value tilt with a higher yielding focus. Furthermore, investors may also like that the fund can avoid some of the worst offenders on a corporate governance and earnings quality front as cold hard cash payouts to investors are pretty hard to fake. Dividend-weighting is used primarily by WisdomTree; the firm has six U.S. focused dividend ETFs and a few international dividend-weighted products as well.

However, investors should note that this method can have its own biases, especially in terms of sector allocations. Funds in this space tend to offer up healthy allocations to companies in the consumer, health care, and energy spaces, while materials and tech tend to make up smaller chunks of the portfolio. Also, it is important to remember that these products are weighted by total cash dividends paid and not yield. This is an important distinction that leads to a lower yield than what many investors are likely expecting for a product focused on dividend payers. In fact, the WisdomTree LargeCap Dividend Fund ( DLN ) offered up a yield of 3.1% at time of writing.

Revenue

For those investors who are focused on the top line, a revenue-weighted ETF could be worth a closer look. This tactic ranks all component securities by top line revenues giving the biggest weights to companies that do the most sales. This could be an intriguing choice for investors who do not like the exclusivity of the dividend or earnings model since while every company may not have either of these items, they all have revenues. Currently, there are six ETFs that use a revenue-weighted methodology, all of which are from upstart firm RevenueShares. The company has products targeting large cap, mid cap, and small caps and also has a financials focused fund ( RWW ) as well as an ADR product ( RTR ) for those seeking international exposure.

While this method intuitively makes sense-more sales equals more weight--- there are still issues with this strategy as well. First off, investors should note that it can be overweight in low margin businesses such as retail, consumer banking, and consumer staples. Meanwhile, on the underweight side, the fund is relatively light, when compared to the S&P 500 in technology, one of the highest margin segments of the economy. This is often because firms in low margin businesses generally need to sell more in order to be as big as their peers in more lucrative industries. For example, Target has roughly the same amount of sales as Microsoft but in terms of gross profit, Microsoft has close to twice Target's figure. Thanks to this, TGT receives a slightly higher weighting in RWL than Microsoft despite the fact that MSFT has a market cap nearly six times TGT.

Equal

Another approach to the weighting question is via equal levels for each component security. This style allocates the same percentage to each company in a benchmark no matter how big or small or how much it has in earnings, dividends, or any other metric. This can result in diversification away from large cap focused funds that are often tilted heavily towards the giants in a particular sector. These funds are also regularly rebalanced back to equal weight which helps to take profits on outperforming components of the index. Those proceeds can then be reinvested in out-of-favor components, resulting in equal and unbiased exposure to the index constituents, a situation that may help investors who aren't disciplined when it comes to selling.

In terms of companies that offer funds following this idea, the space isn't exclusive to any one firm. With that being said, Rydex definitely leads the way on the equal weight front, offering the most out of any single issuer. The company has equal weight products targeting all of the U.S. sectors as well as ETFs for large, mid, and small cap exposure as well. Lastly, the company also has a few equal weight products in the international market, giving investors the ability to build an entire equity portfolio with equally-weighted ETFs.

Equal weighting's flaws, unlike many of the other product classes on this list, do not really stretch into sectors too much. With that being said, there are some biases towards sectors where there are a lot of firms-such as financials or tech-and away from the spaces where only a few firms exist, such as utilities, telecom, or materials. Instead, these funds can often be overweight in volatile small cap securities and can thus underperform when investors are fleeing risky assets. So while the S&P 500 equal weight fund RSP has outperformed SPY in the past, with a shaky market environment it underperforms and can fall behind.

Fundamental

Beyond the alternatives outlined above, investors also have a number of options that take a more 'fundamental' approach to investing. These techniques use a metric or a variety of data points in order to determine weighting levels making funds that follow this strategy unlike any of the others outlined above. For investors seeking to learn more about this investing style, consider these three tactics:

  • RAFI- This style, which stands for Research Affiliates Fundamental Index, involves selecting and weighting securities by fundamental measures of company size, as opposed to market capitalization. This involves using barometers such as company sales, profits and dividends and coming up with weights based on a multifactor approach. This strategy can also break the link between price and weight but a look at a portfolio based on this methodology can lead to similar top holdings as cap-weighted funds (although the weights are by no means identical).
  • FirstTrust AlphaDEX- AlphaDEX seeks to rank stocks on growth and value factors and then only give weights to the best companies in each ranking. In fact, the securities that rank in the bottom 25% are eliminated from the portfolio while the remaining stocks are divided into quintiles based on their rankings. Then, weights are assigned to each quintile with the most going to the top quintile and stretching lower, although within each quintile stocks are equally-weighted. This could result in a portfolio that could outperform, especially if the company's weighting strategy only invests in the best companies as it hopes to do. The main downside to this strategy is the expense; fees can often run around the 0.7% mark, a level that can be-depending on the asset class-much more expensive than low cost options in the space or even other alternative styles.
  • Russell Factor ETFs- These ETFs which use a factor such as momentum, volatility, or beta, give investors yet another option for an alternative to market cap weighting. In this method, companies that have the highest metric-such as volatility-are given the highest weighting. While this does help to produce a portfolio different than a cap-weighted fund, it can lead to concentration in a particular sector. For example, the firm's high beta ETFs are tilted towards durable goods and tech companies while the low volatility fund has heavy weights in consumer staples and utilities.

 
Zacks Investment Research



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: DLN , EPI , RTR , RWW

Zacks.com

Zacks.com

More from Zacks.com:

Related Videos

Stocks

Referenced

Most Active by Volume

74,972,696
  • $16.29 ▲ 1.24%
58,110,176
  • $63.0301 ▲ 2.92%
52,113,540
  • $4.30 ▲ 4.37%
45,053,607
  • $26.18 ▲ 3.40%
40,556,519
  • $3.22 ▲ 0.94%
33,697,770
  • $50.83 ▲ 1.90%
33,642,638
  • $4.56 ▲ 2.01%
31,530,460
  • $20.06 ▲ 11.88%
As of 4/22/2014, 04:07 PM